No, the banks are not fixed

People often ask if regulators and legislators have fixed the flaws in the financial system that took the world to the brink of a second Great Depression. The short answer is no.

Yes, the chances of an immediate repeat of the acute financial meltdown of 2008 are much reduced by the fact that most investors, regulators, consumers and even politicians will remember their financial near-death experience for quite some time. As a result, it may take a while for recklessness to hit full throttle again.

But otherwise little has fundamentally changed. Legislation and regulation produced in the wake of the crisis have mostly served as patches to preserve the status quo. Politicians and regulators have neither the political courage nor the intellectual conviction needed to return to a much clearer and more straightforward system.

In his recent speech to the annual elite central-banking conference in Jackson Hole, Wyoming, the Bank of Englandâs executive director for financial stability, Andy Haldane, made a forceful plea for a return to simplicity in banking regulation.

Haldane rightly complained that banking regulation has evolved from a small number of very specific guidelines to mind-numbingly complicated statistical algorithms for measuring risk and capital adequacy.

Legislative complexity is growing exponentially in parallel. In the US, the Glass-Steagall Act of 1933 was just 37 pages long and helped to produce financial stability for the greater part of seven decades. The recent Dodd-Frank Wall Street Reform and Consumer Protection Act is 848 pages long, and requires regulatory agencies to produce several hundred additional documents with even more detailed rules. Combined, the legislation is on track to run to 30,000 pages.

As Haldane says, even the celebrated âVolcker ruleâ, intended to build a better wall between more mundane commercial banking and riskier proprietary bank trading, has been hugely watered down as it grinds through the legislative process. The former Federal Reserve chairmanâs simple idea has been co-opted and diluted through hundreds of pages of legalese.

The problem, at least, is simple: as finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race in which underfunded government agencies have no chance.

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Even back in the 1990s, regulators privately complained of the difficulty of retaining staff capable of understanding the rapidly evolving derivatives market.

Research assistants with one year working on derivatives issues would get bid away by the private sector at salaries five times what the government paid.

Around the same time, in the mid-1990s, academics began to publish papers suggesting that the only effective way to regulate modern banks was a form of self-regulation. Let banks design risk management systems, audit them to the limited extent possible, then severely punish them if they produce a loss outside agreed parameters.

Many economists argued these clever models were flawed because the punishment threat was not credible, particularly in the case of a systemic meltdown affecting a large part of the financial system.

But the papers were published anyway, the ideas implemented. It is not necessary to recount the consequences. The clearest and most effective way to simplify regulation has been advanced in a series of important papers by Anat Admati of Stanford (with co-authors including Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer). Their basic point is that financial firms should be forced to fund themselves in a more balanced fashion, and not to rely so heavily on debt finance.

Admati and her colleagues recommend requirements that force financial firms to generate equity funding either through retained earnings or, in the case of publicly traded firms, stock issuance. The status quo allows banks instead to leverage taxpayer assistance by holding razor-thin equity margins, relying on debt to a far greater extent than do large non-financial firms. Some large firms, such as Apple, hold virtually no debt. Greater reliance on equity will give banks a much larger cushion to absorb losses.

The financial industry complains that efforts to force greater equity funding will curtail lending, but this is just nonsense in a general equilibrium setting. Nevertheless, governments have been very timid in advancing on this front, and the new Basel III rules take only a baby step toward real change.

Of course, it is not easy to legislate financial reform in a stagnant global economy, for fear of impeding credit and turning a sluggish recovery into a full-blown recession.

And, surely, academics are also to blame for the inertia, as many still defend elegant but deeply flawed models of perfect markets that create an illusion of safety for a system that is in fact highly risk-prone.

The fashionable idea of allowing banks to issue âcontingent capitalâ (debt that becomes equity in a systemic crisis) is no more credible than the idea of committing to punish banks severely in the event of a crisis. A simpler and more transparent system will ultimately lead to more lending and greater stability, not less. It is high time to restore sanity to financial market regulation.